Senator Johnson Named Senate Banking Committee Chair

Senator Tim Johnson (D-SD) will be the new Chair of the Senate Banking Committee for the 112th Congress. Senator Johnson said that he is committed to making US financial regulations world class and ensuring that consumers and investors are meaningfully protected. From the perspective of the Banking Committee, this will include overseeing the implementation of the Dodd-Frank Act and beginning housing finance reform. Senator Richard Shelby (R-ALA) will continue as the Committee’s Ranking Member.

During the House-Senate conference committee on Dodd-Frank, Senator Johnson vetted a compromise provision on a uniform federal fiduciary standard for brokers and investment advisers. The provision required an SEC study under strict parameters, which has now been filed.

Big Four Believe that PCAOB Should Clarify ``Failure to Supervise’’ within Quality Control System

While supporting the PCAOB’s objective to clarify failure to supervise under Section 105(c)(6) of Sarbanes-Oxley and enhance documentation of these responsibilities, the Big Four audit firms believe that this effort should be implemented through the quality control project already on the Board's agenda. The consensus is that a separate rulemaking on supervision is not necessary. If the Board nonetheless decides to institute such a rulemaking, it should not do so before it has completed the QC project.

A PCAOB Concept Release examines issues relating to the responsibilities of an accounting firm and its supervisory personnel with respect to supervision (PCAOB Release No. 2010-005). Section 105(c)(6) of Sarbanes-Oxley authorizes the Board to impose sanctions on accounting firms and their supervisory personnel for failing reasonably to supervise associated persons who have violated certain laws, rules, or standards.

In its comment letter on the Concept Release, KPMG said that effective supervision is fundamental to any system of audit quality control and permeates all quality control elements designed and maintained collectively to provide reasonable assurance that a firm’s personnel are complying with applicable professional standards and regulatory and legal requirements, and with the firm’s standards of quality. The strength of a firm’s control environment is influenced by the extent to which individuals understand their responsibilities, recognize that they will be held accountable and understand the related implications of that accountability. Documentation of a firm’s supervisory structure would enable a clearer understanding of responsibilities in the context of the respective system of audit quality control. That clearer understanding supports the effective operation of a system of audit quality control.

Thus, due to the pervasive impact of supervision on any system of quality control, reasoned KPMG, it is most appropriate for any documentation requirement relative to supervision assignments and responsibilities contemplated in the Concept Release be considered in the context of the broader quality control standards project. Any supervisory responsibility documentation requirement proposed by the Board should be made part of the quality control standards and considered in the context of a firm’s system of audit quality control in its entirety.

While the Concept Release suggests that the supervisory structure imposed on broker-dealers may present an appropriate model for supervision of public accounting firms, KPMG believes that the broker-dealer model of supervision does not provide a useful guide for constructing rules for supervision of the auditing profession. The NASD rules under which broker-dealer supervision is maintained are highly detailed and prescriptive and are intended to give definitive guidance in a business with a rigid hierarchical structure wholly unlike that of an accounting firm.

These detailed requirements are inconsistent with the nature of supervision effected by registered public accounting firms and their personnel in fulfilling their respective obligations pursuant to the Board’s professional standards. While the SEC has brought charges in the broker-dealer arena challenging the actions and judgments of more senior officers and supervisors, those cases are highly fact-specific and do not present practical direction in the context of accounting firm supervision.

Echoing these comments, Ernst & Young said that the Board should not adopt separate failure to supervise rules but rather should clarify responsibilities within the existing quality control framework. The Board should consider expanding the quality control standards to clarify supervisory duties. While Sarbanes-Oxley Sec. 105(c)(6)(B) tracks the broker-dealer duty to supervise language of Exchange Act Sec. 15(b)(4)(E), E&Y pointed out that the structure of an audit firm is different from that of a brokerage firm. Enforcement cases against broker-dealer supervisors are generally brought for violation of their duty to supervise securities salespersons. The activities of audit firm personnel, by contrast, have little in common with the activities of registered representatives. For example, the activities of audit engagement teams involve the extensive exercise of professional judgment.

Deloitte also commented that efforts related to clarifying or adding to supervisory
responsibilities should be accomplished through revision to the PCAOB’s quality control standards. Similarly, in its comment letter. PricewaterhouseCoopers urged the Board to consider revising the existing standards to incorporate a requirement for additional documentation relating to supervision and monitoring within the quality control standards that meets Board's objectives. PwC believes that supervision requirements would be better defined in the context of existing QC and auditing standards, which are designed to establish comprehensive professional standards governing how firms conduct audits, than in separate stand-alone rules overlaid on top of applicable QC and auditing standards.

There was also a consensus at a recent meeting of the Board’s Standing Advisory Group that failure to supervise should be baked into quality control. John Archambault, Grant Thornton senior partner, said that the issue of failure to supervise flows into quality control standards. The main thrust of failure to supervise rules is that audit firm personnel need to know who has what responsibilities. Mary Hartman Morris, Calpers Investment Officer for Global Equity, said that failure to supervise is one more step toward audit quality and is tied to key quality performance indicators. Steven Rafferty of BKD added that if Board inspections are finding that the failure to supervise is a failure of people to do their jobs then it is part of the quality control system.

Chinese Corporate Governance Improved by Passage of Legislation and Adoption of a Code

The corporate governance of Chinese public companies has improved dramatically since the passage of the Company Law of 2006 and the Securities Law of 2006 and the adoption of a Code of Corporate Governance based on the legislation, according to an OECD report. Chinese corporate governance is characterized by the increasing reliance on independent directors and a strong role for independent audit and compensation committees.

The Company Law and the Securities Law provide the foundation for drawing up and developing a corporate governance framework in China. The Company Law improved companies’ governance structure and mechanisms to protect lawful shareholders' rights and public interests. It highlighted the legal obligations and duties of those in actual control of the company, such as the directors and senior management. It improved companies' financial accounting systems, internal controls, and the systems governing corporate mergers, divisions and liquidation.

The Securities Law improved the system governing the issuance, trading, registration and settlement of securities and provided for the establishment of multi-tiered capital-market architecture. It improved the supervision of listed companies and increased the legal responsibilities of the controlling shareholders or those actually in control, namely the directors, supervisors and senior management of listed companies. The Securities Law strengthened investor protection, especially for minority investors, established a securities investor protection fund, and defined the system of civil responsibility to compensate for damages to investors.

The Code of Corporate Governance was drawn up in line with the basic principles established by the Company Law and Securities Law. The Code governs shareholders and shareholders’ meetings, listed companies and controlling shareholders, directors and board of directors, and information disclosure and transparency. The Code comprises the main measurement criteria used to judge whether a listed company has a sound corporate governance structure.

The Code provides that independent directors must account for more than one-third of the board in a listed company. Independent directors must be independent of their employer and the company’s main shareholders. Independent directors must hold no other position but that of independent director. In China, an independent director may in principle serve on the board of at most five listed companies as an independent director.

An independent director has a fiduciary obligation and an obligation of diligence toward the company and all of its shareholders. Independent directors must perform their duties without interference from the main shareholders or actual controllers, or other entities or individuals that have a material interest in the company.

The Code says that a company’s board may set up special committees on audit, compensation and nomination, with independent directors making up more than half of the committee member. In audit committees, at least one independent director should have an accounting background. Each special committee may engage intermediaries to provide professional opinions, with expenses paid by the company.

The Code of Corporate Governance provides that the main duties of the compensation committee are studying the appraisal standard for directors and managers, conducting appraisals, and making recommendations, as well as reviewing the company’s compensation policies. The main duties of the audit committee are engaging the company’s outside auditor, overseeing internal audit and the interaction between internal and external audit, inspecting the company’s financial information and its disclosure; and monitoring the company’s internal control system.
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The Company Law requires directors to comply with the duties of loyalty and care. Under the duty of care, directors must not divert, misappropriate or lend the company’s capital, or serve as guarantors of the company’s capital. They must not misappropriate the company’s funds or deposit the company’s assets in their own personal accounts. They must not take advantage of their positions or seek for themselves or others a commercial opportunity that should fall to the company.

The Code of Corporate Governance stipulates that a listed company must establish fair and transparent standards and procedures for the assessment of the performance of directors and executives. The evaluation of the directors and executives must be conducted by the board of directors or by its compensation committee. The evaluation of the performance of independent directors must be conducted through a combination of self-review and peer review.

In addition, the Code requires a company to establish an incentive mechanism linking executive compensation with the company’s performance and the individuals' performance. The performance assessment of management must become a basis for determining the compensation and other pay and bonus arrangements for the person reviewed. Executive compensation is subject to approval by the board of directors, and must be disclosed and explained at the shareholders’ meeting.

There are aspects to China's institutional framework for the equitable treatment of shareholders. First, the regime ensures shareholders' equitable participation in corporate governance through equal voting power, low-cost participation in corporate governance by shareholders, cumulative voting rights and the right to make proposals. The Company Law provides that shareholders individually or jointly holding 3 percent of the shares of the company may, ten days prior to the general meeting, submit a temporary written proposal to the board of directors. The board must, within two days of receiving the proposal, inform other shareholders and submit the proposal to the general meeting of shareholders for deliberation.

Chairman Bachus Asks SEC and CFTC How Much Dodd-Frank Regulations Will Cost

In a letter to the Chairs of the SEC and CFTC, House Financial Services Committee Chair Spencer Bachus (R-Ala) asked for information on the costs to each agency of implementing Dodd-Frank regulations and the annual execution of Dodd-Frank mandates. Specifically, the Chair asked for the amount of their FY 2011 budget request and how much that differs from the FY 2010 budget request, and estimates for the FY2012 budget request. The Chairman asks how much of these budget amounts is attributable to the execution of Dodd-Frank. He also wants to know what each agency has budgeted to implement Dodd-Frank and what percent of the full budget this represents. The same letter was also sent to the FDIC and the Fed and Professor Elizabeth Warren, who is assisting Treasury in setting up the Bureau of Consumer Financial Protection. The agencies must respond to the Chairman’s request by Feb. 10, 2011.

The Chair also asks how many new staff members the SEC and CFTC plan to hire to carry out the Dodd-Frank mandates and how many hires have been made since the passage of the Act on July 21, 2010. Also, the committee wants to know what contracts have been entered into since passage to purchase new equipment, lease office space or hire new consultants. The agencies must also disclose any managerial changes and plans and mission statements they have made to implement and maintain Dodd-Frank.

Chairman Bachus also wants to know what fees the Commissions plan to impose or increase to increase funding. Noting that Dodd-Frank mandates the creation of new offices and divisions, the Chair wants information on plans to create these new offices, the number of employees needed to staff them, and the funding needs of

Shareholder Cannot Maintain Derivative and Federal Securities Fraud Actions Simultaneously against Same Company

A shareholder could not maintain a derivative action against a company while simultaneously maintaining his own individual federal securities fraud action against the same company, ruled a federal judge, since the shareholder could not fairly and adequately enforce a right of the corporation while suing that corporation. The shareholder is engaging in the litigation equivalent of riding two horses until the rider determines which is stronger and faster, said the court, and a willingness to cast aside a derivative claim if it is the slower and weaker horse does not speak well of a person's adequacy as a representative of others. Thus, the court concluded that the derivative action could not proceed with the shareholder acting as the derivative plaintiff. (In re Bank of America Securities and ERISA Derivatives Litigation, 19 Civ. 1234 (PKC), Dec. 14, 2010).

The shareholder is individually seeking damages from the company under the Exchange Act for violations of securities antifraud provisions while simultaneously standing in the company’s shoes to claim that the company was damaged by officer and director misconduct. Under the 1934, the shareholder claims injury caused by misstatements and omissions made by the company with regard to an acquisition. The derivative action asserts common-law claims on behalf of the company against directors and officers alleged to have injured the company through material misstatements and omissions.

Federal courts have long found that plaintiffs attempting to advance derivative and direct claims in the same action face an impermissible conflict of interest. Since this shareholder owned 70,000 shares in the company purchased for over $2 million, noted the judge, his personal recovery under the federal securities claims could be substantial. The court further noted that the derivative action was filed slightly less than one year after the federal securities action and, given the complaints' similar factual allegations, the one year lag does not reflect a zealous approach to the derivative claim.

SEC Defers Creation of Dodd-Frank Mandated Investor Advisory Committee

Citing budgetary concerns, the SEC has deferred the creation of the Investor Advisory Committee mandated by Section 911 of Dodd-Frank. The Act requires the creation of an Investor Advisory Committee within the SEC and authorizes appropriations for its implementation and operation. The committee is designed to advise and consult with the SEC on regulatory priorities and issues regarding securities products, trading strategies, fee structures and the effectiveness of disclosures, as well as initiatives to protect investor interests and promote investor confidence. Late last year, due to budgetary uncertainty, the SEC has put on hold the creation and staffing of the Office of Whistleblower Protection and four other new Offices mandated by the Dodd-Frank Act.

Hong Kong Courts Support SFC’s Corporate Governance Actions

Hong Kong courts have issued rulings backing the Securities and Futures Commission actions against company directors and thereby enhancing the corporate governance of listed companies. Recently, the SFC achieved a breakthrough in investor protection by obtaining orders in the High Court to disqualify company directors on new grounds, namely the failure to make timely disclosure of material information to shareholders. In addition, the SFC obtained a court order directing the company to commence civil proceedings to seek recovery of compensation for the loss and damage suffered by the company as a result of directors’ misconduct

In another action, two former executive directors were disqualified from being directors or being involved in the management of any corporation, without leave of the court, for five years and two years respectively. Both directors accepted that they failed to manage the company with the necessary degree of skill, care, diligence and competence as reasonably expected of persons of their knowledge and experience holding their offices and functions within the company and failed on a number of occasions to ensure that the company complied with the disclosure requirements under the Listing Rules and to give shareholders all the information they might reasonably expect.

The Commission has noted that company directors are in positions of substantial trust and responsibility. As such, they have an obligation to ensure the market is properly informed. Directors who breach their obligations, commit misconduct or keep bad news to themselves when it should be disclosed, cause real damage to the company, their shareholders and the market. Directors also have an obligation to ensure that the company reports material information to the investing public on a timely basis. Failure to do so destroys transparency, trust and confidence in the market, emphasized the Commission.

In commencing proceedings to seek compensation orders, explained the Commission, it does not seek to make directors personally responsible for financial losses that are incurred in good faith. Rather, the SFC focuses on cases where alleged misconduct and bad faith by directors have led to the loss of shareholders’ funds. There is no reason why shareholders should pay for losses caused by directors’ misconduct, reasoned the Commission.

GAO Dodd-Frank Mandated Study on Financial Planners Sees No Need for More Regulation; But Identifies Consumer Issues

While finding no need for additional regulation of financial planners at this time, the GAO recommended that the SEC incorporate into its ongoing review of financial literacy among investors an assessment of the extent to which investors understand the titles and designations used by financial planners, GAO found confusion here, and any implications a lack of understanding may have for consumers’ investment decisions. In a study mandated by Section 919C of Dodd-Frank, the GAO also urged the SEC to collaborate with state securities regulators to identify methods to better understand the extent of problems specifically involving financial planners and financial planning services, and take actions to address any problems that are identified.

The study found that existing statutes and regulations appear to cover the great majority of financial planning services, and individual financial planners nearly always fall under one or more regulatory regimes. The SEC has issued guidance that broadly interprets the Investment Advisers Act to apply to most financial planners because the advisory services they offer clients typically include providing advice about securities for compensation. Similarly, the states take a similar approach on the application of investment adviser laws to financial planners and, as a result, generally register and oversee financial planners as investment advisers. Moreover, financial planners that provide brokerage services are subject to broker-dealer regulation at the federal and state levels.

In addition, under Section 1011 of Dodd-Frank, the Bureau of Consumer Financial Protection regulates the offering and provision of consumer financial products or services under the federal consumer financial laws. Dodd-Frank defines a financial product or service to include financial advisory services to consumers on individual financial matters, with the exception of advisory services related to securities provided by a person regulated by the SEC or a state securities commission to the extent that such person acts in a regulated capacity. Thus, in GAO’s view, the Bureau may have jurisdiction over financial planners to the extent that they may offer services that would not be under the jurisdiction of the SEC or a state securities commission.

With all this in mind, the GAO concluded that, while no single law governs the broad array of activities in which financial planners may engage, an additional layer of regulation specific to financial planners is not warranted at this time. At the same time, more robust enforcement of existing laws could strengthen oversight efforts. In addition, there are some actions that can be taken that may help address consumer protection issues associated with the oversight of financial planners.

The GAO is concerned about investor confusion over the different titles used by individuals who provide financial planning services, such as financial planner, financial consultant, and financial adviser. GAO noted that Section 917 of Dodd-Frank requires the SEC to conduct a study identifying the existing level of financial literacy among retail investors, including the most useful and understandable relevant information that they need to make informed financial decisions before engaging a financial intermediary.

While the section does not specifically mention the issue of financial planners’ titles and designations, GAO believes that the confusion over titles used by financial planners could potentially be addressed or mitigated if the SEC incorporated this issue into its overall review of financial literacy among investors. SEC staff told GAO that their review would not likely address this issue, although it would address such things as the need for conducting background checks on financial professionals. Financial markets function best when consumers have information sufficient to understand and assess financial service providers and products, noted GAO, and so including financial planners’ use of titles and designations in the SEC’s financial literacy review could provide useful information on the implications of consumers’ confusion on this issue

The GAO study also found that the SEC has limited information on the extent to which the activities of financial planners may be causing consumers harm. While the Commission does record and track whether federal and state-registered investment adviser firms provide financial planning services, said GAO, its data tracking systems for complaints, examination results, and enforcement actions are not programmed to readily track whether the complaint, result, or action was specifically related to a financial planner or financial planning service.

For example, the SEC staff told GAO that the number of complaints about financial planners would be undercounted in their data system that receives and tracks public inquiries, known as the Investor Response Information System, because this code would likely be used only if it could not be identified whether the person or firm was an investment adviser or broker-dealer. In addition, the data system that the SEC uses to record examination results, known as the Super Tracking and Reporting System, does not allow the agency to identify and extract examination results specific to the financial planning services of investment advisers.

However, SEC staff told GAO that a review of its Investor Response Information System identified 51 complaints or inquiries that had been recorded using their code for issues related to “financial planners” between November 2009 and October 2010, often involving allegations of unsuitable investments or fraud. The SEC staff also said that they did not have comprehensive data on the extent of enforcement activities related to financial planners per se.

In addition, NASAA said that states generally do not track enforcement data specific to financial planners. At GAO’s request, the SEC and NASAA provided examples of enforcement actions related to individuals who held themselves out as financial planners. Using a keyword search, the SEC identified 10 such formal enforcement actions between August 2009 and August 2010. According to SEC documents, these cases involved allegations of such activities as defrauding clients through marketing schemes, receiving kickbacks without making proper disclosures, and misappropriation of client funds. Although NASAA also did not have comprehensive data on enforcement activities involving financial planners, representatives provided GAO with examples of 36 actions brought by 30 states from 1986 to 2010. These cases involved allegations of such things as the sale of unsuitable products, fraudulent misrepresentation of qualifications, failure to register as an investment adviser, and misuse of client funds for personal expenses.

Because of limitations in how data is gathered and tracked, SEC and state securities regulators are not currently able to readily determine the extent to which financial planning services may be causing consumers harm. The SEC and state securities regulators do not routinely track potential problems specific to financial planners. SEC and NASAA representatives told GAO that they have been meeting periodically in recent months to prepare for the transition from federal to state oversight of certain additional investment adviser firms, as mandated under the Dodd-Frank Act, but that oversight of financial planners in particular had not been part of these discussions. SEC staff noted that additional tracking could consume staff time and other resources. They also said that because there are no laws that directly require registration, recordkeeping, and other responsibilities of financial planners per se, tracking such findings relating to those entities would require expenditure of resources on something that SEC does not have direct responsibility to oversee.

While recognizing the need to balance the cost of data collection efforts against the usefulness of the data, GAO believes that a regulatory system should have data sufficient to identify risks and problem areas and support decision making. Given the significant growth in the financial planning industry, ongoing concerns about potential conflicts of interest, and consumer confusion about standards of care, GAO suggested that securities regulators should identify ways to get better information on the extent of problems specifically involving financial planners and financial planning services.

House Bill Would Apply FOIA to Government-Sponsored Enterprises

House Bill Would Apply FOIA to Government-Sponsored Enterprises
A bill introduced by Rep. Jason Chaffetz (R-UT) would apply the Freedom of Information Act to Fannie Mae and Freddie Mac during periods when these GSEs are in conservatorship or receivership, as they are now. The measure (HR 463) is designed to achieve a level of transparency and accountability in federal agencies. The legislation is co-sponsored by House Financial Services Committee Chair Spencer Bachus (R-ALA) and the committee’s Deputy Chair Jeb Hensarling (R-TX), who introduced major GSE reform legislation in the 111th Congress.

Another co-sponsor of the bill, House Oversight Committee Chair Darrell Issa said that Fannie Mae and Freddie Mac are being run by the federal government to achieve objectives set by the federal government. As long as this continues, he emphasized, it is common sense that they should be subject to FOIA requests.

The Hensarling bill, HR 4889, would have set a deadline for the Director of the Federal Housing Finance Agency to terminate the conservatorship of either Fannie Mae or Freddie Mac if the Director determines that it is financially viable. It would also instruct the Director to establish minimum levels of capital for the enterprises and deem failure of an enterprise to maintain revised minimum capital levels to constitute an unsafe and unsound condition. Moreover, the bill would prohibit the enterprises from purchasing and securitizing mortgages that exceed the median area price for the affected property.

SEC Staff Study Mandated by Dodd-Frank Recommends Enhancing Investor Access to Data on Brokers and Advisers

The SEC staff has recommended a unified public disclosure database for accessing information about brokers and advisers pursuant to a study on how to improve investors’ access to information about these financial intermediaries mandated by Section 919B of Dodd-Frank. Alternatively, the staff recommended unifying search returns for the existing BrokerCheck and IAPD tools while continuing to maintain them as separate databases. BrokerCheck and IAPD are Web-based disclosure systems providing investors access to information about brokers and advisers, such as employment history and disciplinary records, that help an investor investigate and evaluate these financial intermediaries.

The gold standard remains centralized access to registration information so that all of the data in the two systems would be in one place, making it easier for investors to obtain useful data. The current disclosure system comprises two distinct registration databases, requiring investors to know which database to search: BrokerCheck or IAPD. For investors who do not know whether their financial services provider is registered as a broker-dealer or an investment adviser, knowing where to conduct a background search may be problematic.

Moreover, not all financial services providers are required to register, including some service providers in the mortgage brokerage or futures industries. Some are exempt from registration or operate outside the Commission’s oversight. Centralizing access would make it more likely that investors could find data about a financial services provider who at any time was registered as a registered representative or investment adviser representative, whether or not they knew the provider’s registration status.

But since Section 919B mandates that any recommendations must be implemented 18 months after completion of the study, the SEC staff felt that practical difficulties would most likely prevent implementing a centralized unified public disclosure database within that timeframe. Thus, the staff recommended as a more feasible alternative the unification of search returns for BrokerCheck and IAPD and increasing the usefulness of these tools in two ways. First, by expanding search functions to permit searches for broker-dealers, investment advisers, registered representatives, and investment adviser representatives, based on ZIP code or other indicator of location. Second, by adding educational content, such as links and definitional material, perhaps embedded in alternate text tags, such as pop-ups or other kinds of hover text, which would appear automatically whenever a user’s electronic cursor hovers over certain text or items on the BrokerCheck and IAPD Web pages.

These functions would provide definitions or other explanatory content to help a user better understand the significance of a particular technical term or reference. Both Forms BD and ADV contain a glossary of terms that could be used to populate the hover text, suggested the staff.

The study also recommends that, subsequent to the eighteen-month implementation period, Commission staff and FINRA continue to analyze, including through investor testing, the feasibility and advisability of expanding BrokerCheck to include information currently available in CRD, as well as the method and format of publishing that information; and that SEC staff continue to evaluate expanding IAPD content and the method and format of publishing that content, including through investor testing. Potential modifications could include adding summary data for advisory firms on IAPD, hyperlinks between CRD numbers and SEC file numbers containing information related to a particular CRD number, and additional links to content available elsewhere on BrokerCheck or IAPD.

More broadly, the study reaffirmed that, because selecting a broker or investment adviser is one of the most important decisions that investors face, information to help them make this choice should be easy to find, easy to use, and easy to understand. The Commission recognizes that investors are entrusting financial intermediaries with their savings and should have sufficient pertinent information available to enable them to select a registered representative with whose background they are comfortable.

SEC and CFTC Propose Joint Form for Hedge Fund Advisers and CPOs to Report Systemic Risk Information

Advisers to hedge funds and other private funds would be required to report information for use by the Financial Stability Oversight Council in monitoring risk to the financial system under rules jointly proposed by the SEC and CFTC. The proposed rules would implement Sections 404 and 406 of the Dodd-Frank Act by creating a new Form PF to be filed periodically by SEC-registered investment advisers who manage one or more private funds. Information reported on Form PF would remain confidential, although the SEC may use Form PF information in an enforcement action.

The SEC believes that proposed Form PF has two principal benefits. First, the information collected through Form PF is expected to facilitate FSOC’s monitoring of the systemic risks that private funds may pose and to assist FSOC in carrying out its other duties under the Dodd-Frank Act with respect to hedge funds ad other nonbank financial companies. Second, this information may enhance the ability of the SEC to evaluate and form regulatory policies and improve the efficiency and effectiveness of the Commission’s monitoring of markets for investor protection and market vitality.

Form PF is a joint form between the SEC and the CFTC only with respect to sections 1 and 2 of the form. Section 3 of the form, which would require more specific reporting regarding liquidity funds, would only be required by the SEC. The information that Form PF would require would be filed through an electronic filing system expected to be operated by an entity designated by the SEC.

The proposed CFTC rules would require commodity pool operators (CPOs) and commodity trading advisors (CTAs) registered with the CFTC to satisfy proposed CFTC filing requirements by filing Form PF with the SEC, but only if those CPOs and CTAs are also registered with the SEC as investment advisers and advise one or more private funds

The coordination with the CFTC would result in significant efficiencies for private fund advisers that are also registered as a CPO or CTA with the CFTC because, under the proposed rules, these advisers would satisfy certain reporting obligations under both proposed Advisers Act rule 204(b)-1 and proposed CEA rule 4.27(d) with respect to commodity pools that satisfy the definition of private fund by filing Form PF.

Under the proposed reporting requirements, private fund advisers are divided by size into two broad groups: large advisers and smaller advisers. The amount of information reported and the frequency of reporting would depend on the group to which the adviser belongs.

Smaller private fund advisers would file Form PF only once a year and would report only basic information regarding the private funds they advise. This would include information regarding leverage, credit providers, investor concentration and fund performance. Smaller advisers managing hedge funds would also report information about fund strategy, counterparty credit risk and use of trading and clearing mechanisms.

Large private fund advisers would file Form PF on a quarterly basis and would provide more detailed information than smaller advisers. The focus of the reporting would depend on the type of private fund that the adviser manages. Large hedge fund advisers would report on an aggregated basis information regarding exposures by asset class, geographical concentration and turnover. In addition, for each managed hedge fund having a net asset value of at least $500 million, these advisers would report certain information relating to that fund's investments, leverage, risk profile and liquidity.

Proposed Form PF would include questions about large hedge funds’ investments, use of leverage and collateral practices, counterparty exposures, and market positions that are designed to assist FSOC in monitoring and assessing the extent to which stresses at those hedge funds could have systemic implications by spreading to prime brokers, credit or trading counterparties, or financial markets. This information also is designed to help FSOC observe how hedge funds behave in response to certain stresses in the markets or economy

Large liquidity fund advisers would provide information on the types of assets in each of their liquidity fund's portfolios, certain information relevant to the risk profile of the fund, and the extent to which the fund has a policy of complying with all or aspects of the Investment Company Act's Rule 2a-7 concerning registered money market funds (Rule 2a-7).

Large private equity fund advisers would respond to questions focusing primarily on the extent of leverage incurred by their funds' portfolio companies, the use of bridge financing, and their funds' investments in financial institutions.
Under the proposal, larger private fund advisers managing hedge funds, liquidity funds such as unregistered money market funds, and private equity funds would be subject to the heightened reporting requirements. Large private fund advisers would include any adviser with $1 billion or more assets under management. All other private fund advisers would be regarded as smaller private fund advisers and would not be subject to the heightened reporting requirements.

The SEC estimates that approximately 4,450 advisers would be required to file all or part of Form PF, with approximately 3,920 being smaller private fund advisers not meeting the thresholds for reporting as Large Private Fund Advisers. Although this heightened reporting threshold would apply to only about 200 U.S.-based hedge fund advisers, these advisers manage more than 80 percent of the assets under management.

The proposed Form PF would define a liquidity fund as a private fund that seeks to generate income by investing in a portfolio of short-term obligations in order to maintain a stable net asset value per unit or minimize principal volatility for investors. Liquidity funds thus can resemble money market funds, which are registered under the Investment Company Act and seek to maintain a stable net asset value per share, typically $1, through the use of the amortized cost method of valuation. Reporting by advisers to liquidity funds is designed to allow FSOC to assess liquidity funds’ susceptibility to runs and ability to otherwise pose systemic risk.

For purposes of determining whether an adviser is a Large Private Fund Adviser for purposes of Form PF, each adviser would have to aggregate together: assets of managed accounts advised by the firm that pursue substantially the same investment objective and strategy and invest in substantially the same positions as the private fund and assets of that type of private fund advised by any of the adviser’s related persons. The aggregation requirements are designed to prevent an adviser from avoiding the proposed Large Private Fund Adviser reporting requirements by restructuring the manner of providing private fund advice internally

Proposed Form PF is the result of extensive consultation and collaboration between SEC staff and other FSOC members. Also, in formulating this proposal, the Commission collaborated with the U.K.'s Financial Services Authority and other members of the International Organization of Securities Commissions. The types of information that IOSCO recommended regulators gather from hedge fund advisers is consistent with and comparable to the types of information the SEC proposes to collect from hedge funds through Form PF.

Key Witness Urges Congress to Fund SEC to Properly Implement the Dodd-Frank Act, While Urging Legislative Changes to D-F

It is unwise to cut the budgets of the SEC and other federal financial regulators in an attempt to control or derail the regulatory reforms prompted by Dodd-Frank, said Hal Scott, Chairman of the Committee of Capital Markets Regulation, in testimony before the House Financial Services Committee. Tightening the purse strings will not stop the rulemaking process, he emphasized, it will only make it worse. Independent agencies deprived of funds will not stop writing rules, he noted, they will only do a worse job or shift resources from other important areas such as enforcement. That said, the Chair agreed with some members of Congress that there are major problems with the implementation of Dodd-Frank, but that they should be fixed through legislation and oversight, not through withholding funds in the appropriations process.

Professor Scott recommended major legislative changes to Dodd-Frank involving proprietary trading under the Volcker provisions, funding for the Bureau of Consumer Financial Protection, and the ban on the use of credit ratings in adopting regulations. More broadly, he also called for the fundamental structural reform of the regulatory system, beyond the creation of the Financial Stability Oversight Council.

The Volcker Rule, codified in Section 619 of Dodd-Frank, prohibits financial institutions from engaging in proprietary trading. Restrictions on proprietary trading are both over- and under-inclusive, said the Chair, over-inclusive because not all banks engage in proprietary trading contributing to systemic risk, and under-inclusive because some non-banks engaged in proprietary trading that may contribute to systemic risk.

He urged regulators to define ``proprietary trading’’ narrowly and then broadly define the various exceptions, such as market making. Also, the definition should be limited to trading activities set up with segregated capital and separate teams of personnel that do not interact with customer businesses or rely on customer deposits.

While Dodd-Frank requires federal agencies to purge from regulations any reference to or requirement of reliance on credit ratings, the Act provides no solution as to what should replace reliance on these ratings beyond calling for uniform standards of creditworthiness for use by each such agency. Professor Scott noted that many important regulations like capital requirements and those of the Investment Company Act rely heavily on credit ratings.

He urged both short and long term action by Congress to correct this problem. In the short term, the Act should be amended to allow the use of credit ratings but forbid undue reliance on them. Although this approach may still give too much influence to the ratings agencies, he conceded, it will give the regulators more flexibility and discretion than an absolute prohibition while the regulators, Congress, and the public determine how to replace credit ratings.

In the longer term, the Congress can explore alternatives. One alternative might be to create a Credit Assessment Panel composed of not only rating agencies, but also other expert firms, like PIMCO, that already provide credit analysis to private financial firms. Each member of the Panel would evaluate creditworthiness using its own proprietary methodology but would provide credit assessments in a standardized format. The government could then use each firm’s contribution in forming a composite assessment. The government itself would be prohibited from devising its own ratings, he noted, and would have to rely exclusively on the input from the Panel. The Panel members would have to be compensated, which he acknowledged would be a major challenge of this approach. In principle, beneficiaries could be charged a fee.

Under Dodd-Frank, the Bureau of Consumer Financial Protection is funded from the profits of the Federal Reserve. The Bureau receives whatever amount its Director determines is reasonably necessary to carry out its authorities, subject to a cap of about $550 million. In Professor Scott’s view, funding the Bureau through Fed profits is problematic because it sets a bad precedent for appropriating Federal Reserve profits to particular budgetary needs. Budgetary determinations should be made through the normal appropriation process, he said, where justification is required.

In 2009, the Committee on Capital Markets Regulation called for the reorganization of the U.S. regulatory structure, calling it “an outmoded, overlapping sectoral model.” According to Professor Scott, the Dodd-Frank Act has not rectified the problem. Urging Congress to make real structural reform a top priority, the Chair said that regulation of the U.S. financial system should be concentrated in no more than three federal regulatory bodies.

Although the Financial Stability Oversight Council has been tasked with some oversight and coordination roles, he noted, it is not a real solution to the fragmented regulatory structure. First, it has little direct supervisory authority since authority remains dispersed among the other agencies. For example, although it has the authority to designate nonbank financial institutions as systemically important, Dodd-Frank places enhanced supervisory authority in the hands of the Federal Reserve. FSOC can make recommendations to the Federal Reserve, but cannot force it to act. Similarly, it can resolve some disputes among agencies, but its recommendations are generally nonbinding. In addition, the two-thirds supermajority vote for many of its actions may be difficult to achieve.

New FASB Chair Reaffirms Commitment to Global Accounting Standards and Supports SEC Financial Reporting Roundtables

Leslie Seidman, new Chair of FASB, said that the Board is very committed to achieving a consistent set of global accounting standards with the IASB. An intensive effort is ongoing to work with the IASB to arrive at a common solution. An example of this approach is the impairment project. But she would not be drawn into predicting when a date certain will be set by the SEC for the full adoption of IFRS in the US. The Chair noted that the SEC has said they will make a decision later this year on how to proceed. The Chair’s remarks came during a FASB webcast on the outlook for 2011.

The new Chair strongly supports the SEC staff Financial Reporting Roundtables as a good opportunity to diagnose the source of a financial reporting problem and designate the correct organization to deal with it. Some financial reporting issues may not involve standard-setting, she said, but may, for example, involve auditor oversight.

Chairman Seidman also noted that the expansion of FASB from five to seven members will provide for more diverse and informed views, including investor and private company voices, at the standard setting table and can only help the Board put out a better proposal. The expanded Board will also be able to reach out more to constituents.

The top joint projects with the IASB are accounting for financial instruments, revenue recognition, and leasing. The projects aim at resolving inconsistencies between GAAP and IFRS. As the projects continue, sometimes GAAP moves towards IFRS, she said, and sometimes IFRS moves towards GAAP.

With regard to accounting for financial instruments, US GAAP and IFRS are different. It is important to attain a workable converged standard that users of financial instruments will have confidence in. She noted that commenters believe that marketable securities should be carried at fair value under the converged standard. The Chair allowed that some other assets could be more usefully classified under cost accounting.

A single global accounting standard for revenue recognition is another high joint FASB-IASB project, along with adequate implementation guidance. Both Boards are committed to a strong revenue recognition standard, said the Chair, since there is a consensus among users of financial statements that revenue recognition is the most important element in the financial statement.

After the high priority projects are completed by mid-year, FASB will turn to deferred projects, such as financial statement presentation. Also, at some point, Chairman Seidman wants FASB staff to identify the remaining differences in US GAAP and IFRS that are not important to investors and weigh whether these differences are worth trying to converge.

Hedge Funds Cannot Bring Rule 10b-5 Action in US Federal Court Based on Swap Agreements Referencing Stock of German Company

Global hedge funds managed by US investment managers could not bring a Rule 10b-5 action in a US federal court against a German car manufacturer (Porsche) based on securities-based swap agreements referencing the share price of another German car company (VW). A federal judge (SD NY) ruled that a party’s execution in the U.S. of a swap agreement that references foreign securities was not enough to overcome the Supreme Court’s Morrison transactional test for the extraterritorial application of Rule 10b-5. The court said that the swap agreements were the functional equivalent of trading the shares of a German company on a German exchange. Moreover, the swap agreements were transacted with undisclosed counterparties who may well have been located outside the United States.

In light of Morrison’s strong pronouncement that U.S. courts ought not interfere with foreign securities regulation without a clear Congressional mandate, the court was loathe to create a rule that would make foreign issuers with little relationship to the U.S. subject to suits here simply because a private party in the US entered into a derivatives contract that references the foreign issuer’s stock. Such a holding, said the court, would turn Morrison’s presumption against the extraterritoriality reach of Rule 10b-5 on its head. (Elliott Associates v. Porsche Automobil Holding SE, SD NY, 10 Civ. 0532, Dec. 30, 2010).


The hedge funds alleged that Porsche caused a dramatic rise in VW stock prices by buying nearly all the freely-traded voting shares of VW as part of a secret plan to take over that company. When Porsche revealed its holdings in VW, the share price shot up and caused enormous losses to the funds, who stood to benefit through their swap agreements from decreases in the VW share price. The hedge funds alleged that Porsche violated Rule 10b-5 when it falsely denied its intent to take over VW, and engaged in a series of manipulative derivatives trades to hide the extent to which the company controlled VW shares.

In Morrison, the Supreme Court explained that the Exchange Act antifraud rule applies only to transactions in securities listed on domestic exchanges, and domestic transactions in other securities. Since the swap agreements at issue were not listed on domestic exchanges, the court’s inquiry focused on whether they constituted domestic transactions in other securities within the ambit of § 10(b).

The hedge funds argued that they signed confirmations for securities-based swap agreements in New York, and therefore engaged in domestic transactions in other securities within the scope of § 10(b). But the court rejected this narrow reading of Morrison as inconsistent with the Supreme Court’s intention to curtail the extraterritorial application of § 10(b). To allow this Rule 10b-5 action to go forward, reasoned the district judge, would extend extraterritorial application of the Exchange Act’s antifraud provisions to virtually any situation in which one party to a swap agreement is located in the United States and thus contravene the Supreme Court’s intent to avoid interference with foreign securities regulation.

Rule 10b-5 applies with equal force to securities and securities-based swap agreements. Although the Exchange Act did not originally contemplate § 10(b) protection for purchasers of derivative instruments such as swaps, Congress expanded the statute in 2000 in order to make explicit that § 10(b) applies to securities-based swap agreements.

But these securities-based swap agreements did not qualify as domestic transactions in other securities under the Supreme Court’s new transactional test. The Supreme Court has routinely emphasized the importance of economic reality in determining whether derivative instruments fall within the ambit of federal securities regulations. Since the economic value of securities-based swap agreements is intrinsically tied to the value of the reference security, noted the court, the nature of the reference security must play a role in determining whether a transnational swap agreement may be afforded the protection of § 10(b).

Since the swaps executed by the hedge funds were the functional equivalent of trading the underlying VW shares on a German exchange, reasoned the court, the economic reality is that the swap agreements are essentially transactions conducted upon foreign exchanges and markets, and not domestic transactions meriting the protection of the antifraud rule.

Washington State Accredited Investor Definition Further Excludes Indebtedness Secured by Primary Residence

Washington State became the first jurisdiction to adopt by rule on January 21, 2011 the Dodd-Frank Act’s amendment to the “accredited investor” definition that excludes the value of a natural person’s primary residence from their net worth calculation if the net worth exceeds $1 million at the time of their purchase of securities. The Washington Securities Division simultaneously effected by interpretive statement an SEC-adopted further exclusion from net worth for the amount of the natural person’s indebtedness secured by their primary residence up to its fair market value, along with an SEC-adopted liability deduction from net worth for the amount of the natural person’s indebtedness secured by their primary residence that exceeds its fair market value. Federal and state securities practitioners submitted comments to the SEC that the Dodd-Frank Act exclusion did not take into account the vast majority of investors having a mortgage on their primary residence rather than owning the property free and clear.

For more information please see Interpretive Statement #23 at http://www.dfi.wa.gov/sd

Japan FSA Extends Restrictions on Short Selling Until End of April

The Japanese Financial Services Agency has extended its restrictions on short selling until April 30, 2011. The restrictions were to have expired on January 31, 2011. Thus, the regulatory measures on short selling currently in place will continue with regard to all listed stocks in Japan. In Japan, the short position reporting requirements cover only equity stock short positions.

There is an uptick rule requirement prohibiting, in principle, short selling at prices no higher than the latest market price. There are also requirements for traders to verify and flag whether or not the transactions in question are short selling and request the exchanges to make daily announcements on their aggregate price of short selling regarding all securities and aggregate price of short selling by sector. The FSA has also prohibited naked short selling.

Moreover, holders of a short position of a certain level or more, in principle 0.25 percent or more of outstanding issued stocks, are required to report to exchanges through securities firms. Exchanges are required to publicly disclose such information.

European Commission Declares US and Nine Other non-EU Countries Equivalent for Inspections of Auditors

The European Commission paved the way for the PCAOB and other non-EU audit overseers and EU audit oversight bodies to mutually rely on each others’ inspections of audit firms by recognizing the equivalence of audit oversight regimes in the US and nine other countries. However, the grant of equivalence to the US was limited to three years, at which time it will be reviewed. In addition to that of the US, the audit oversight systems of Australia, Canada, China, Croatia, Japan, Singapore, South Africa, South Korea, and Switzerland were deemed equivalent.

As the demand for companies to operate globally increases, noted the Commission, so too does the need for their auditors to do the same. With auditing now moving beyond national borders, there is a need for effective global auditor oversight, which requires extensive international cooperation. It is for this reason that the Commission supports international mutual reliance on the regulation of auditors that is carried out by their home country audit oversight. Mutual reliance means that EU Member States and non-EU states, called third countries by the Commission, can rely on each others' inspections of audit firms allowing for a more effective and efficient oversight of global audit firms.

Europe supports mutual reliance on the oversight of auditors by their home country oversight system. Under the EU doctrine of mutual reliance, Member States and third countries which have been declared equivalent can agree to rely on the regulatory work of the other. In the Commission’s view, the US is still in the process of moving towards this objective. Nonetheless, the Commission recognizes the need to have a temporary solution in place. For this reason, the decision with regard to the US is limited in time enabling the EU to reassess the situation in three years. Specifically, the decision with respect to the US is set to terminate on July 31, 2013.

The equivalence decision comes against the backdrop of the Commission’s consideration of the entire market for the audit of financial statements, noted Commissioner for the Internal Market Michel Barnier, and should be seen within that wider context. Commissioner Barnier said that international cooperation on audit oversight is crucial to avoid overburdening audit firms and duplicating the work of the PCAOB and other oversight bodies, while the same time promoting investor protection and ensuring high quality audits.

With the Commission decision now in place, Member States may choose to rely on the oversight work of one of the 10 third country oversight systems, which have been assessed as equivalent. The Commission noted that equivalence decisions on third country public auditor oversight systems do not provide any automatic or immediate rights to auditors from the concerned third country. After the Commission adopts an equivalence decision, it is up to Member States to decide, based on mutual reliance, to what extent they wish to rely on the public auditor oversight system of the third country concerned. The extent of this reliance and cooperation is set out in cooperative arrangements, which must be signed by both a Member State and a third country to be operational.

A third country may be assessed as equivalent if its system for public auditor oversight is assessed as meeting the requirements set out in the Statutory Audit Directive (Directive 2006/43/EC) which governs public oversight, quality assurance or inspection and investigation and penalty systems of the Member States.

UK Commission Considers Volcker-Type Structural Reforms for UK Financial Institutions

The UK should consider ring-fencing the retail banking activities of systemically-important financial institutions from their investment banking activities and require them to be capitalized on a stand-alone basis, said Sir John Vickers, Chair of the Independent Commission on Banking. In remarks at the London School of Business, he said that a variant of this idea would be to require the ring-fenced retail banking activities to be relatively strongly capitalized, while adopting a lighter regulatory policy towards the other activities, thereby focusing on and limiting the need for heightened capital requirements on the key retail services. Chairman Vickers mentioned the Volcker Rule provisions of the Dodd-Frank Act as the type of structural reform that the Commission is considering. Formed by the Government in June of 2010, the Commission will produce an interim report in April and in September will make final recommendations to the Government on reform of the regulation of UK financial institutions.

The remarks of Chairman Vickers may help allay the concerns of Spencer Bachus (R-Ala), Chair of the House Financial Services Committee who, in a letter urging federal financial regulators to interpret the Volcker provisions of the Dodd-Frank Act in a way that does not disadvantage US financial firms in competition with EU firms, said that the Volcker provisions collide with the European universal banking model that the EU is highly unlikely to abandon in the spirit of regulatory harmonization. Given the City of London’s significance as a world financial center, noted Chairman Bachus, the UK’s failure to adopt the Volcker provisions would result in a significant competitive disadvantage for US firms.

Chairman Vickers noted that one of the arguments made in favor of universal banking is that it allows diversification of risks with the result that the probability of bank failure is lower than if retail and investment banking are in some way separated. But he said that diversification by itself is not a good justification for corporate integration insofar as investors can achieve its benefits through portfolio diversification. He also said that it does not follow that retail bank failure is less likely with universal banking.

In this respect universal banking has the advantage that a sufficiently profitable or well-capitalized investment banking operation may be able to cover losses in retail banking. But it has the disadvantage that unsuccessful investment banking may bring down the universal bank, including the retail bank. If the Commission recommends some form of separation similar to the Volcker Rule as a matter of public policy, he continued, there would be the further question of whether it should be required of the financial institutions concerned, or incentivized, for example by appropriately different capital requirements for different business models.

Separately, Chairman Vickers noted that, because normal bankruptcy procedures work so badly for large, complex and interconnected financial institutions, it is imperative to develop credible recovery plans and resolution tools similar to the liquidation regime codified in Title II of Dodd-Frank. Much work is under way in the UK and internationally to tackle this problem. The resolvability of global investment banking operations is a particular challenge, and of heightened importance to the UK given the scale of bank balance sheets relative to GDP.

In the Chair’s view, a credible resolution authority would seem to require some form of separability and. Arguably, there is a case for some form of ex ante separation so that bank operations whose continuous provision is truly critical to the functioning of the economy can clearly be easily and rapidly carved out in the event of calamity. But he added that perhaps the credibility of resolution plans can be ensured otherwise than by forms of separation, and the benefits of creating such options would of course need to be weighed carefully against costs they imposed. There is also the possibility that some form of structural separation of retail and investment banking might enhance the credibility and effectiveness of resolution schemes.

Contingent Capital

The Chair also said that using a contingent capital tool, which converts debt into equity at times of stress, is somewhat problematic. Potential problems with automatic conversion are that the triggering conditions are lagging, or otherwise somewhat arbitrary, indicators of the need for more equity, or else that they are subject to manipulation by speculative market traders. On the other hand, discretionary triggers may run into problems of price uncertainty, regulatory capture by vested interests, and reluctance to activate the trigger when the time comes). The system-wide dynamic effects of conversions at times of emerging systemic stress might also be unpredictable.

These scenarios are compounded by a tax system that encourages both corporate and personal leverage. The corporate tax deductibility of debt interest increases the private cost of equity relative to debt. In the case of financial institutions, therefore, the public desirability of more equity capital meets an opposing force from the tax system.

SEC Study Mandated by Dodd-Frank Recommends Uniform Federal Fiduciary Standard for Brokers and Advisers; Divided Commission Sends Study to Congress

Based on its review of the broker-dealer and investment adviser industries pursuant to a study mandated by Dodd-Frank Section 913, the SEC staff recommended the adoption of a uniform federal fiduciary standard for brokers and advisers that would be no less stringent than the standard currently applied to investment advisers under Advisers Act Sections 206(1) and (2). The new standard would apply expressly and uniformly to both brokers and investment advisers when providing personalized investment advice about securities to retail customers. In the staff’s view, the uniform standard should be designed to increase investor protection and decrease investor confusion in the most practicable, least burdensome way for investors, brokers and investment advisers. More specifically, the study said that the standard should provide that the broker or adviser must act in the best interest of the customer without regard to the financial or other interest of the broker or investment adviser providing the advice.

In a separate statement, Commissioners Kathleen Casey and Troy Paredes opposing sending the staff study to Congress as drafted because it does not fulfill the mandate of Section 913 to evaluate the effectiveness of existing legal or regulatory standards of care applicable to brokers and investment advisers. In their view, the study's pervasive shortcoming is that it fails to adequately justify its recommendation that the Commission embark on fundamentally changing the regulatory regime for broker-dealers and investment advisers providing personalized investment advice to retail investors.

In the study, the staff noted that Section 913 explicitly provides that the receipt of commission-based compensation, or other standard compensation, for the sale of securities does not, in and of itself, violate the uniform fiduciary standard of conduct applied to a broker-dealer. Section 913 also provides that the uniform fiduciary standard does not necessarily require broker-dealers to have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice. Indeed, during the House-Senate conference on Dodd-Frank that hammered out the compromise Section 913, House Financial Services Chair Barney Frank said that Congress did not envision a uniform fiduciary standard containing a continuing duty to retail investors.

In a comment letter to the SEC, SIFMA urged the SEC to define the scope of the term ``personalized investment advice’’ as used in Dodd-Frank but left undefined by the legislation. If the term is interpreted too broadly, cautioned SIFMA, retail customers could be cut off from investment opportunities even if they are making the investment decision without a specific recommendation. In order to simultaneously protect retail customers and provide them access and choice, SIFMA recommended that the term “personalized investment advice” be defined to mean and apply only to investment recommendations provided to address the objectives of a specific retail customer after taking into account the customer’s specific circumstances.

The SEC staff urged the Commission to define ``personalized investment advice’’ to encompass the making of a recommendation, as developed under applicable broker-dealer regulation, and to not include impersonal investment advice as developed under the Advisers Act. Beyond that, the staff believes that the term also could include any other actions or communications that would be considered investment advice about securities under the Advisers Act (such as comparisons of securities or asset allocation strategies), except for impersonal investment advice as developed under the Advisers Act.

Either in the rulemaking or separate guidance, the SEC staff study urged the Commission to identify specific examples of potentially relevant and common material conflicts of interest in order to facilitate a smooth transition to the new standard by brokers and consistent interpretations by brokers and investment advisers. In the staff’s view, the existing guidance and precedent under the Advisers Act regarding fiduciary duty, as developed primarily through SEC interpretations under the antifraud provisions of the Advisers Act, and through case law and numerous enforcement actions will continue to apply.

A uniform standard of conduct will obligate both investment advisers and brokers to eliminate or disclose conflicts of interest. Thus, the study urges the Commission to prohibit certain conflicts and facilitate the provision of uniform and simple disclosures to retail investors about the terms of their relationships with brokers and investment advisers, including any material conflicts of interest. The Commission should consider which disclosures might be provided most effectively in a general relationship guide akin to the new Form ADV Part 2A that advisers deliver at the time of entry into the retail customer relationship, and in more specific disclosures at the time of providing investment advice.

The staff said that the Commission also should consider the utility and feasibility of a summary relationship disclosure document containing key information on a firm’s services, fees, and conflicts and the scope of its services. It may be appropriate to adopt rules prohibiting certain conflicts, to require firms to mitigate conflicts through specific action, or to impose specific disclosure and consent requirements.

Further, in the interest of harmonization, the Commission should consider whether to modify the Advisers Act books and records requirements, including by adding a general requirement to retain all communications and agreements, including electronic information and communications and agreements, related to an adviser’s “business as such,” consistent with the standard applicable to brokers.

While Section 913(g) of Dodd-Frank does not require the standard of care to include the principal trading restrictions of Section 206(3) of the Advisers Act, the SEC staff urged the Commission to address through interpretive guidance and/or rulemaking how broker-dealers should fulfill the uniform fiduciary standard when engaging in principal trading. In its comment letter to the SEC, SIFMA said that Congress did not include these restrictions because it would have inappropriately deprived retail customers of the benefits of access to broker inventories of a range of securities. Thus, SIFMA urged the SEC not to apply the trade-by-trade disclosure and consent requirements of Section 206(3) to principal transactions that are subject to the uniform standard of care where the broker or investment adviser does not have discretionary authority regarding the customer account.

Treasury and Fed Respond to Chairman Bachus’ Request for Information on new Bureau of Consumer Financial Protection

Responding to a request for transparency from House Financial Services Chair Spencer Bachus, Treasury and the Federal Reserve Board indicated that the new Bureau of Consumer Financial Protection plans to have three mission-related directorates: Education and Engagement; Supervision and Enforcement; and a Research, Markets, and Rules division with three components: a research team that studies consumer behavior and product risks; a rulemaking team that drafts rules, interpretations, and guidance; and a markets team that focuses on understanding and monitoring markets for individual products, such as mortgages, credit cards, and student loans. The Bureau implementation team also plans to include an Office of Small Business and Community Banks within the Bureau’s organizational structure.

Section 1066 of Dodd-Frank authorizes Treasury to perform the functions of the Bureau until the first Director of the Bureau is nominated by the President and confirmed by the Senate; and Treasury may provide administrative services before the designated transfer date, which Secretary Tim Geithner has set as July 21, 2011. President Obama named Professor Elizabeth Warren as Treasury Special Advisor on the Consumer Financial Protection Bureau.

Responding to a specific request from Chairman Bachus that Bureau officials study the organizational changes that the SEC and other federal financial regulators made in response to criticisms in the wake of the financial crisis, Professor Warren assured the Chair that she will ensure that lessons learned from other regulatory agencies are considered as the Bureau sets its enforcement priorities.

In his November letter to Treasury, Chairman Bachus also said that he wanted to see more transparency and accountability in the process of establishing the new Bureau, adding that, in sharp contrast to the approach taken by the SEC and CFTC in implementing Dodd-Frank, Treasury had provided little or no transparency in its activities implementing the Bureau for eventual hand-off to the Fed, where it will reside.

In the response letter to Chairman Bachus, Treasury officials said that the organizational plan is a “work-in-progress,” and that the Bureau implementation team expects to continue modifying the plan going forward. Treasury officials also stated that the Bureau implementation team’s draft budgets for FY 2011 and FY 2012 will be included in the President’s FY 2012 request, which traditionally is released at the end of January or beginning of February.

The Bureau implementation team expects that the three directorates will work together to ensure that policy initiatives are tailored to identified problems and that any policy initiatives that affect consumer risk, affordability, and access are appropriately estimated. Treasury officials stated that the Bureau of the Public Debt’s Administrative Resource Center (ARC) will provide the Bureau with financial management services to ensure that financial systems and processes comply with federal laws and regulations. The Bureau implementation team is in the process of developing the Bureau’s policies and procedures and determining whether to continue using ARC or implement a different financial management system after the transfer date.

According to Treasury and the Fed, the ongoing independent oversight provided by the Inspector Generals is another means for safeguarding against waste, fraud, and abuse within the Bureau’s programs and operations. Additionally, the new Bureau will be subject to external oversight by Congress and the Government Accountability Office is responsible for conducting an annual audit of the financial transactions of the Bureau. For its part, the Bureau is required to provide GAO with an assertion as to the effectiveness of its internal controls for financial reporting.

The letter assured Chairman Bachus that the Treasury Secretary is not authorized to prescribe rules under the Bureau’s rulemaking authority prior to the designated transfer date. Until that date, rulemaking authority under federal consumer financial law remains with the federal regulatory agencies that currently have such rulemaking responsibilities. In addition, since the Secretary is not authorized to prescribe rules prior to the designated transfer date, reasoned the federal officials, the Secretary cannot delegate this authority.

However, if confirmed by the Senate, the Director of the Bureau is granted a limited amount of rulemaking authority prior to the designated transfer date. While the Secretary is not authorized to prescribe rules prior to the designated transfer date, Treasury is considering whether it will issue advance notices of proposed rulemaking (ANPRs), which, according to Treasury, do not contain substantive rules, but are a means of gathering information and input, before the transfer date.

According to Treasury officials, the Bureau implementation team is also using informal channels, including public forums and meetings with industry representatives, to collect information regarding the Bureau’s rulemaking considerations. In addition, the Bureau implementation team intends to include a page on the Bureau’s website, which should be launched by the end of January 2011, where the public can provide its input on any number of topics relating to the Bureau.

Professor Warren and the Bureau implementation team are in the process of identifying priorities for rulemaking proceedings to be undertaken after the designated transfer date. Professor Warren believes that cost savings, improved regulatory compliance, and simplified consumer disclosures are among the factors being considered in establishing the rulemaking priorities. In addition, Professor Warren and members of the team have met with staff from the financial regulators that will be transferring rulemaking authority to the Bureau in an effort to better understand existing regulatory priorities.

Professor Warren has informally collected public input through meetings with industry representatives and consumer groups. In addition, according to Treasury, Bureau officials are continuing to meet with members of the public to obtain input with respect to rulemaking priorities. The Bureau also intends to collect public input on rulemakong through its website.

Similarly, the Treasury Secretary is not authorized to conduct supervisory examinations prior to the designated transfer date. Until that date, consumer compliance examinations may be conducted by the regulatory agencies that have examination authority under current law. However, during the interim period, the Secretary may exercise the Bureau’s authority to have Bureau examiners participate (on a sampling basis) in the current regulators’ compliance examinations of depository institutions with total assets greater than $10 billion, and any affiliate thereof. In addition, if nominated by the President and confirmed by the Senate, the Director is authorized to conduct supervisory
examinations of nondepository institutions prior to the designated transfer date.

The Bureau implementation team is developing plans, policies, procedures, and staffing levels for the Bureau’s enforcement function. While the Bureau has not yet established priorities for enforcement activities that will be undertaken after the designated transfer date, the recent hiring of implementation team leaders for enforcement and nondepository and depository supervision will enhance the priority-setting process.

SEC Enforcement Action Alleges that Senior Officers Misled Outside Auditors in Revenue Recognition Scheme

An SEC enforcement action alleged that senior corporate officials misled the company’s outside audit firm as part of a fraudulent accounting scheme to inflate revenues. The SEC alleged that the company overstated its sales revenues by booking false sales and engaging in improper revenue recognition practices. The Commission charged the company’s former CEO and CFO and corporate secretary for their roles in the fraudulent accounting scheme. The SEC also charged the former controller and the former director of financial services for improper accounting. SEC v. NutraCea, DC Ariz. CV-11-0092-PHX-DGC, AAER No. 3324.

Without admitting or denying the SEC's allegations, the former CEO, corporate secretary, controller and financial services director agreed to settle the action and to the entry of permanent injunctions. The CEO was permanently barred from serving as an officer or director and the secretary agreed to a five year bar. The accounting professionals agreed to be barred for at least one year from SEC practice. The action continues against the former CFO, alleging that he violated and aided and abetted violations of the antifraud, books and records, financial reporting, internal controls, and lying to auditors provisions of the federal securities laws.

The SEC said that in the second quarter of fiscal year 2007 the company improperly recorded a $2.6 million sale of four different products to a purported customer. The company had attempted to book revenue from the sale of these same products to three different customers in the previous quarter, but the outside auditors disagreed with the company’s assessment that revenues from the sales were appropriately recognized. The CEO fought hard to convince the outside auditors that the revenue from these first quarter sales should be booked. However, the outside audit firm refused to change its position and made the company reverse the revenue, causing a shortfall in revenues by 47% from the same period one year before.
In the next quarter, the CEO was determined to recognize revenue from the sale of these same products. Specifically, he approached the customer’s president and asked him to issue purchase orders for $2.6 million of product. According to the SEC, this transaction was a complete sham since the customer had no intention of purchasing and selling these products.

Under SEC SAB No. 104, collectability must be reasonably assured before revenue can be recognized. In this instance, reasoned the SEC, collection of the receivable could not be reasonably assured because of the customer’s precarious financial condition and the dubious nature of the sales arrangement. To further substantiate this sham sale and to support recognizing the entire sale in the second quarter, the CEO worked out a $1 million loan from the company’s former COO to the customer to enable the customer to make a down payment on the $2.6 million purchase

Despite their knowledge that the $1 million down payment on the $2.6 million sale was from the company’s former COO’s loan, the CEO, CFO and the two accounting professionals failed to disclose this information to the outside auditors. Instead, they affirmatively misled the auditors when they all signed a management representation letter related to the auditors’ review of the interim financial information of the second quarter Form 10-Q falsely representing that the interim financial information was presented in accordance with GAAP, all financial records and related data were made available to the auditors, and they had no knowledge of any fraud or suspected fraud affecting the company involving management, employees who have significant roles in the internal control, or others where fraud could have a material effect on the interim financial information.

Dodd-Frank Mandated SEC Study Offers Congress Choice of Users Fees or SROs to Enhance Investment Adviser Oversight

An SEC study mandated by the Dodd-Frank Act recommended users fees or an SRO as a way to enhance the effectiveness of the oversight of investment advisers. At a time when the Commission’s registered investment adviser examination program faces significant capacity challenges, the study recommended imposing user fees on SEC-registered investment advisers to fund an SEC examination program, authorizing one or more SROs to examine, subject to SEC supervision, all SEC-registered investment advisers, or authorizing FINRA to examine dual registrants for compliance with the Advisers Act. In a separate statement, Commissioner Walter supported the SRO option because it would have significant and long-term benefits to investors and the Commission, but she does not believe that there has to be a single SRO or that it has to be FINRA.

Section 914 of the Dodd-Frank Act requires the Commission to review and analyze the need for enhanced examination and enforcement resources for investment advisers and report to Congress on regulatory or legislative steps necessary to address concerns identified in the study.

The study comes amidst a fierce debate over whether FINRA could or should be an effective SRO for investment advisers. To deal with what FINRA has called an ``intractable resource problem,’’ FINRA has urged the SEC to seek legislation establishing an SRO for investment advisers to augment the government’s efforts in overseeing advisers. The debate over an SRO for advisers has intensified with industry associations voicing strong opposition to the idea.

According to the SEC study, user fees imposed upon registered investment advisers would provide scalable resources to support the examination of registered investment advisers. Under this approach, the Commission would continue to rely on appropriated funds to support its other programs, including other aspects of its administration of the Advisers Act. The fees collected from investment advisers would be available to the Commission without further appropriation and be used solely to fund the investment adviser examination program, as well as be set at a level designed to achieve an acceptable frequency of examinations. While the Commission collects transaction and registration fees under the securities laws from issuers of securities and other market participants, these fees currently are required to be deposited and credited as offsetting collections to the account providing appropriations to the Commission.

The idea of funding the Commission’s investment adviser examination program by charging user fees is not new. In 1992, a bill was introduced in the House of Representatives that would have provided that registered investment advisers pay a user fee to finance their oversight by the Commission

Imposing user fees to adequately fund the examination program may be a less expensive option than an SRO, noted the SEC, although the staff has not evaluated the potential start-up or operational costs of an SRO. User fees are also an option that some advisory organization support as an alternative to an SRO.

The costs of going the SRO route could vary substantially depending upon whether there were multiple SROs or a single SRO, and whether any SRO designated is already in operation and thus could potentially incur fewer start-up costs. Also, the Commission would continue to bear expenses associated with overseeing one or more SROs.

Congress could, alternatively, authorize one or more SROs for registered investment advisers in order to provide scalable resources to support the Commission’s examination of registered investment advisers. SROs are privately funded entities with market specific expertise that, subject to Commission oversight, can have the authority to adopt rules, examine member firms for compliance with those rules and the federal securities laws, and enforce those rules and laws.

However, the implementation of one or more investment adviser SROs would require resolution of a number of important issues regarding the number, scope of authority, membership, governance, and funding. These issues are complicated by the diversity of the investment adviser industry and strong industry opposition.

The diversity of the investment advisory industry, ranging from small, locally-operated financial planning firms to global money managers suggests the potential for multiple SROs, each of which could oversee a different type of investment adviser. However, multiple SROs also could lead to regulatory arbitrage, as SROs seek to attract members by offering a more accommodating regulatory and oversight program or by charging lower fees leading to inadequate funding for regulatory programs.

Congress could provide for an SRO with broad authority or opt for an intermediate approach and grant an SRO limited examination authority over investment advisers, while maintaining the Commission as the sole holder of authority to develop regulatory policy under the Advisers Act.

The governance of any investment adviser SRO is critical because governance is the primary mechanism through which an SRO can manage the conflicts of interest that exist when an organization regulates its own members that also compete with each other. Given the diversity in the investment advisory industry, an appropriate governance structure is important to prevent one business model from dominating the SRO or the SRO from providing a competitive advantage to particular business models.

A third and less comprehensive approach could be to amend the Exchange Act to expressly permit FINRA to examine all of its members that are also registered as investment advisers for compliance with the Advisers Act. Currently, the Exchange Act provides FINRA with authority to enforce its members’ compliance with the Exchange Act and SEC rules under the Act but does not provide it with express authority to enforce compliance with the Advisers Act. Thus, SEC staff conduct examinations of dual registrants for compliance with the Advisers Act in addition to, and separate from, FINRA’s examinations.

While only about five percent of investment advisers registered under the Advisers Act are broker-dealers and thus members of FINRA, almost all of the largest retail broker-dealers are also registered as investment advisers. These dual registrants have a substantial portion of retail advisory clients and employ a significant number of investment adviser representatives.
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Authorizing FINRA to enforce the Advisers Act would free existing Commission resources spent examining dual registrants to be re-directed to other investment advisers. Moreover, it would partially address the inefficiencies that result from subjecting a dual registrant to two separate examinations. It would permit a single regulator, having obtained a more holistic view of dual registrants’ client activities and compliance environment, to conduct a more effective examination of a dual registrant. Such examinations also could be more cost efficient.

But authorizing FINRA to examine all operations of dual registrants is not without drawbacks. The Commission staff may lose experience examining these large retail advisers, and may not gain important information about their activities. Further, there would be a risk that, over time, different and inconsistent approaches to applying the Advisers Act to dual registrants and other advisers could develop. The Commission would have to exercise vigilant oversight to prevent this from occurring.

In her statement, Commissioner Walter said that the SRO model should increase the frequency of examinations of investment adviser and thus directly answer the question that Congress posed to the SEC in Dodd-Frank. Moreover, an SRO would allow the SEC to transfer more of its resources in this area to complex and emerging issues at a time when they are most needed and permit the Commission to do its job with fewer but more expert resources. The SRO option would also add significant resources outside the Commission to support the agency’s mission and increase speed and efficiency through SRO processes that are more expedited than those used by the government. Significantly, noted the Commissioner, the user fee option does not necessarily provide any of these benefits.

Commssioner Walter also noted that, while the study raised the specter that the SRO model would undermine the expertise of SEC staff, ``that certainly does not have to be the case.’’ Indeed, the SRO would allow the SEC to do its job with a smaller examination workforce and, by eliminating the need to perform a large number of routine examinations, provide the opportunity for that smaller group to be more expert and experienced.

Subprime-Fueled Financial Crisis Was Intervening Cause of Investors’ Loss Thereby Precluding Rule 10b-5 Recovery

Shareholders of a failed bank alleging that the FDIC’s announcement that it was taking over the bank caused the value of their stock to decline did not adequately allege loss causation under Rule 10b-5, ruled a federal judge (ND GA), since they failed to distinguish losses caused by the bank’s alleged misrepresentations and the intervening subprime crisis that wreaked havoc on the banking industry as a whole. Far from establishing that the alleged misrepresentations caaused their loss, the shareholders established instead that the loss was caused by the FDIC’s decision to close the bank due to the effect of the subprime mortgage and financial crises on the bank’s loan portfolio and the value of its real estate collateral. Patel v. Patel, No. 1:09-CV-3684-CAP, July 14, 2011.

When investors’ loss coincides with a market-wide phenomenon causing comparable losses to other investors, reasoned the court, the prospect that the loss was caused by fraud decreases, noted the court, and a claim fails when it has not adequately pled facts which if proven would show that he loss was
caused by the alleged misstatements as opposed to intervening events. Even if the defendants’ misconduct induced shareholders to make the investment, said the court, if their loss is caused by supervening general market forces or other factors unrelated to that misconduct that operated to reduce the value of the securities, the shareholders are precluded from recovery under Rule 10b-5.

Texas Proposes Form D Electronic Filing, Accredited Investor Definitions and IA Part 2 of Form ADV Requirement

The Electronic Form D (EFD) System being developed by the North American Securities Administrators Association (NASAA) for multi-state electronic filing of 2008-adopted Form D was proposed for use in Texas by the State Securities Board, along with new definitions for accredited investors, individual accredited investors and institutional accredited investors, and the use of new Part 2 of Form ADV by investment adviser applicants and registrants.

Rule 505 and 506 of federal Regulation D. Issuers making an offering under either Rule 505 or 506 of federal Regulation D would electronically submit Form D and the applicable fee through the EFD System when that system becomes available. "Form D," Notice of Exempt Offerings of Securities, would be the Form D that took effect on September 15, 2008. The "EFD System" would be the Electronic Form D system provided by the North American Securities Administrators Association (NASAA) to be used for electronic filing of Form D with the Texas Securities Commissioner. The consent to service of process requirement would be eliminated for Rule 506 offerings. Issuers would file a notice on Form D accompanied by the applicable fee. NOTE: The notice and fee payment, as well as any applicable notice and fee payment for excess sales, would be electronically submitted through the EFD system when that system becomes available.

Intrastate limited offering exemption. Issuers not registered as securities dealers and who do not sell securities by or through a registered securities dealer would file a sworn notice on Texas Form 133.29, Intrastate Exemption Notice for Sales Under Regulation 109.13(l), not less than 10 business days before any sale exempt under this exemption is consummated in whole or in part to individual accredited investors. The definition of an "individual accredited investor" for this intrastate limited offering exemption would be a natural person described in Rule 501(a)(5) and (6) as promulgated by the SEC under the Securities Act of 1933.

No notice would be required for sales made exclusively to institutional accredited investors. The definition of an "institutional accredited investor" for this intrastate limited offering exemption would be an entity described in Rule 501(a)(1) - (4), (7) and (8) as promulgated by the SEC under the Securities Act of 1933. An accredited investor would include any person who the issuer reasonably believes comes within the definition of an accredited investor at the time of the sale of the securities to that person. The definition of an "accredited investor" for this intrastate limited offering exemption would be a person who is either an individual accredited
investor or an institutional accredited investor.

Investment advisers. An initial investment adviser registration application would consist of items electronically submitted through the IARD including a Form ADV, Uniform Investment Adviser Registration Application, a Form U-4, Uniform Application for Securities Industry Registration or Transfer, for the designated officer and for each investment adviser representative or solicitor to be registered, a disclosure document or Part 2 of Form ADV, and the registration fee of $275 for the investment adviser and $235 for the designated officer and each investment adviser representative to be registered. The items filed in paper format directly with the Securities Commissioner would be a copy of the particular entity's articles, a prescribed balance sheet, a copy of the investment adviser's advisory contract, a fee schedule and any other information considered necessary for the Securities Commissioner to determine the investment adviser's financial responsibility and/or the investment adviser's or investment adviser representatives' business repute or qualification. NOTE: Uniform forms electronically filed with the IARD designating Texas as a jurisdiction where filing will be made are considered "filed" with the Securities Commissioner and constitute official Securities Board records.

For more information please see http://www.ssb.state.tx.us/